Negative and positive gearing

Profit or loss

Many people borrow to invest; this is called 'gearing'. The more
you borrow, the more you will pay in interest. If you have borrowed
to invest and you're making a profit, you are positively geared. If
you're making a loss, you are negatively geared. Either way,
gearing is still costing you money.

What is negative
gearing?

Negative gearing is where you borrow money to invest and the
income from the investment is less than the expenses. This is
common for property investments, for
example, where rental income is less than interest and other
expenses. Essentially this means you are making a loss.

If you borrow money to invest in sharesyour investment will be
negatively geared if the dividends from the shares are less than
the interest on the loan.

You may be prepared to accept a loss if you expect to be able to
offset your losses with a capital gain in the future when the value
of the investment increases. An investment loss will reduce your
taxable income which will reduce the amount of tax you pay.

Keep in mind that if you are making a loss your investment is
costing you money. You will need another source of income to fund
the extra expenses.

What is positive
gearing?

Positive gearing is where you borrow money to invest
andthe income from your investment is higher than
your interest and other expenses. This means you will have extra
money in your budget but you will have to pay tax on the additional
net income.

Positively geared investments provide ongoing income and a capital
gainif it has increased in value when you sell the
investment.

Positive vs negative gearing

Many investors focus on the tax benefits of negative gearing
without considering the loss in after tax income. The following
example shows the difference between buying an investment property
that is negatively geared and buying a property that is positively
geared.

Case study: Comparing negatively and positively geared
properties

Rod and Karen are brother and sister and both earn around
$70,000 per year. They are both thinking about buying an investment
property worth $400,000. Interest on an investment loan will be 6%
pa, payable on an interest-only basis. Additional property expenses
are estimated at $5,000 a year. Rental income is expected to be
$500 a week.

Rod will need to borrow the $400,000 needed to buy his
investment apartment as he has no savings. Interest on the loan is
$2,000 a month, which is tax deductible.

Karen has some money saved so she only needs to borrow $100,000
for a similar apartment. Karen's interest payment is $500 a month,
which is also tax deductible.

Rod and Karen's income before buying an investment
property

Rod's negatively geared investment property

Karen's positively geared investment property

Salary

$70,000

$70,000

$70,000

Plus rental income

-

$26,000

$26,000

Less interest

-

-
$24,000

- $
6,000

Less property expenses

-

-
$ 5,000

- $
5,000

Taxable income

$70,000

$67,000

$85,000

Tax + Medicare levy

-
$15,167

-
$14,132

-
$20,567

NET INCOME

$54,833

$52,868

$64,433

Assumptions:

Tax + Medicare levy includes the low and middle income tax
offset.

Example reflects the interest payable in the first year. Over
time this will decrease but so will the tax benefits.

It does not take into account inflation, increases in rental
income or changes to interest rates or income tax rates over
time.

Capital growth is not taken into account as it does not affect
income calculations. The same capital gain would be applicable
under either scenario.

Karen is positively geared so her income is considerably higher
than Rod's. If Karen had left her money in a savings account
earning 5% interest, her after tax income would be the same,
however a savings account has no potential for capital gain.

Rod actually has less money in his pocket as most of his rental
income is being paid to the bank in interest so he has to cover
some of his investment expenses from employment income. He will be
hoping a future capital gain will recoup his short-term income
losses.

Negative gearing is a popular tax
minimisationstrategy, but remember, you only
reduce your tax if you reduce your income. If you are borrowing to
invest, choosing a positively geared investment will increase your
income and increase your overall return on investment.